1. Copyright ©1998 Ian H. Giddy EquityValuation 2 1

2. Equity Valuation: Application Prof. Ian Giddy New York University New York University/ING Barings

3. Copyright ©1998 Ian H. Giddy EquityValuation 2 3 Equity Instruments l Estimating discount rate l Estimating cash flows l Application to Disney

4. Copyright ©1998 Ian H. Giddy EquityValuation 2 4 Estimating Inputs: Discount Rates l Critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. l At an intutive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted.

5. Copyright ©1998 Ian H. Giddy EquityValuation 2 5 I. Cost of Equity l The cost of equity is the rate of return that investors require to make an equity investment in a firm. There are two approaches to estimating the cost of equity;  a risk and return model  a dividend-growth model. l Using the CAPM, for instance, gives you a cost of equity based upon the beta of the equity in the firm.

6. Copyright ©1998 Ian H. Giddy EquityValuation 2 6 II. Cost of Capital l It will depend upon:  (a) the components of financing: Debt, Equity or Preferred stock  (b) the cost of each component l In summary, the cost of capital is the cost of each component weighted by its relative market value. l WACC = k e (E/(D+E)) + k d (D/(D+E))

7. Copyright ©1998 Ian H. Giddy EquityValuation 2 7 Reviewing Disney’s Costs of Equity & Debt BusinessE/(D+E)Cost of D/(D+E)After-tax Cost of Capital EquityCost of Debt Creative Content82.70%14.80%17.30%4.80%13.07% Retailing82.70%16.35%17.30%4.80%14.36% Broadcasting82.70%12.61%17.30%4.80%11.26% Theme Parks82.70%13.91%17.30%4.80%12.32% Real Estate66.67%12.08%33.33%4.80%9.65% Disney 81.99%13.85%18.01%4.80%12.22% l Disney’s Cost of Debt (based upon rating) = 7.50%

8. Copyright ©1998 Ian H. Giddy EquityValuation 2 8 Estimating Cost of Capital: Disney l Equity  Cost of Equity =13.85%  Market Value of Equity = $50.88 Billion  Equity/(Debt+Equity ) =82% l Debt  After-tax Cost of debt =7.50% (1-.36) =4.80%  Market Value of Debt =$ 11.18 Billion  Debt/(Debt +Equity) =18% l Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

9. Copyright ©1998 Ian H. Giddy EquityValuation 2 9 Estimating Income: FCFE when Leverage is Stable Net Income - (1-  ) (Capital Expenditures - Depreciation) - (1-  ) Working Capital Needs = Free Cash flow to Equity  = Debt/Capital Ratio For this firm,  Proceeds from new debt issues = Principal Repayments + d (Capital Expenditures - Depreciation + Working Capital Needs)

10. Copyright ©1998 Ian H. Giddy EquityValuation 2 10 Cashflow to Firm ClaimholderCash flows to claimholder Equity InvestorsFree Cash flow to Equity Debt HoldersInterest Expenses (1 - tax rate) + Principal Repayments - New Debt Issues Preferred StockholdersPreferred Dividends Firm =Free Cash flow to Firm = Equity InvestorsFree Cash flow to Equity + Debt Holders+ Interest Expenses (1- tax rate) + Preferred Stockholders+ Principal Repayments - New Debt Issues + Preferred Dividends

11. Copyright ©1998 Ian H. Giddy EquityValuation 2 11 A Simpler Approach EBIT ( 1 - tax rate) + Depreciation - Capital Spending - Change in Working Capital = Cash flow to the firm

12. Copyright ©1998 Ian H. Giddy EquityValuation 2 12 Estimating FCFF Disney l EBIT = $5,559 Million l Capital spending = $ 1,746 Million l Depreciation = $ 1,134 Million l Non-cash Working capital Change = $ 617 Million l Estimating FCFF EBIT (1-t) $ 3,558 + Depreciation $ 1,134 - Capital Expenditures $ 1,746 - Change in WC $ 617 = FCFF $ 2,329 Million

13. Copyright ©1998 Ian H. Giddy EquityValuation 2 13 Expected Growth in EPS g EPS = Retained Earnings t-1 / NI t-1 * ROE = Retention Ratio * ROE = b * ROE Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

14. Copyright ©1998 Ian H. Giddy EquityValuation 2 14 Estimating Expected Growth in EPS: Disney, Aracruz and Deutsche Bank CompanyROERetentionExp. ForecastRetentionExp RatioGrowthROERatioGrowth Disney24.95%77.68%19.38%25%77.68%19.42% Aracruz2.22%65.00%1.44%13.91%65.00%9.04% Deutsche Bank7.25%39.81%2.89%14.00%45.00%6.30% ROE: Return on Equity for most recent year Forecasted ROE = Expected ROE for the next 5 years  For Disney, forecasted ROE is expected to be close to current ROE  For Aracruz, the average ROE between 1994 and 1996 is used, since 1996 was a abnormally bad year  For Deutsche Bank, the forecast ROE is set equal to the average ROE for German banks

15. Copyright ©1998 Ian H. Giddy EquityValuation 2 15 Growth and ROE l You attempting to estimate expected growth for The Gap and J.P. Morgan. The Gap has a return on equity of 25% and pays out 30% of its earnings as dividends. J.P. Morgan has a return on equity of 15% and pays out 50% of its earnings as dividends. Estimate the expected growth rate for each of these companies –  The Gap’s expected growth =  J.P. Morgan’s expected growth = l What is the ceiling on the expected growth?

16. Copyright ©1998 Ian H. Giddy EquityValuation 2 16 ROE and Leverage l ROE = ROC + D/E (ROC - i (1-t)) where, ROC = (Net Income + Interest (1 - tax rate)) / BV of Capital = EBIT (1- t) / BV of Capital D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / BV of Debt t = Tax rate on ordinary income l Note that BV of Assets = BV of Debt + BV of Equity.

17. Copyright ©1998 Ian H. Giddy EquityValuation 2 17 Decomposing ROE: Disney in 1996 l Return on Capital = (EBIT(1-tax rate) / (BV: Debt + BV: Equity) = 5559 (1-.36)/ (7663+11668) = 18.69% l Debt Equity Ratio = Debt/Market Value of Equity = 45.00% = 8.98% l Interest Rate on Debt = 7.50% l Expected Return on Equity = ROC + D/E (ROC - i(1-t)) = 18.69 % +.45 (18.69% - 7.50(1-.36)) = 24.95%

18. Copyright ©1998 Ian H. Giddy EquityValuation 2 18 Expected Growth in EBIT And Fundamentals l Reinvestment Rate and Return on Capital g EBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC= Reinvestment Rate * ROC l Proposition 2: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital. l Proposition 3: The net capital expenditure needs of a firm, for a given growth rate, should be inversely proportional to the quality of its investments.

19. Copyright ©1998 Ian H. Giddy EquityValuation 2 19 Estimating Growth in EBIT: Disney l Actual reinvestment rate in 1996 = Net Cap Ex/ EBIT (1-t)  Net Cap Ex in 1996 = (1745-1134)  EBIT (1- tax rate) = 5559(1-.36)  Reinvestment Rate = (1745-1134)/(5559*.64)= 7.03% l Forecasted Reinvestment Rate = 50% l Real Return on Capital =18.69% l Expected Growth in EBIT =.5(18.69%) = 9.35% l The forecasted reinvestment rate is much higher than the actual reinvestment rate in 1996, because it includes projected acquisition. Between 1992 and 1996, adding in the Capital Cities acquisition to all capital expenditures would have yielded a reinvestment rate of roughly 50%.

20. Copyright ©1998 Ian H. Giddy EquityValuation 2 20 Return on Capital, Profit Margin and Asset Turnover l Return on Capital = EBIT (1-t) / Total Assets = [EBIT (1-t) / Sales] * [Sales/Total Assets] = After-tax Operating Margin * Asset Turnover l Thus, a firm can improve its return on capital in one of two ways:  It can increase its after-tax operating margin  It can improve its asset turnover, by selling more of the same asset base l This is a useful way of thinking about  choosing between a low-price, high-volume strategy and a high-price, lower-volume strategy  the decision of whether to change price levels (decrease or increase) and the resulting effect on volume

21. Copyright ©1998 Ian H. Giddy EquityValuation 2 21 Firm Characteristics as Growth Changes VariableHigh Growth Firms tend to Stable Growth Firms tend to Riskbe above-average riskbe average risk Dividend Payoutpay little or no dividendspay high dividends Net Cap Exhave high net cap exhave low net cap ex Return on Capitalearn high ROC (excess return)earn ROC closer to WACC Leveragehave little or no debthigher leverage

22. Copyright ©1998 Ian H. Giddy EquityValuation 2 22 Estimating Stable Growth Inputs l Start with the fundamentals:  Profitability measures such as return on equity and capital, in stable growth, can be estimated by looking at q industry averages for these measure, in which case we assume that this firm in stable growth will look like the average firm in the industry q cost of equity and capital, in which case we assume that the firm will stop earning excess returns on its projects as a result of competition.  Leverage is a tougher call. While industry averages can be used here as well, it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are, use current leverage; if they are not; use industry averages) l Use the relationship between growth and fundamentals to estimate payout and net capital expenditures.

23. Copyright ©1998 Ian H. Giddy EquityValuation 2 23 Estimate Stable Period Payout g EPS = Retained Earnings t-1 / NI t-1 * ROE = Retention Ratio * ROE = b * ROE l Moving terms around, Retention Ratio = g EPS / ROE Payout Ratio = 1 - Retention Ratio = 1 - g EPS / ROE

24. Copyright ©1998 Ian H. Giddy EquityValuation 2 24 Estimating Stable Period Net Cap Ex g EBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC= Reinvestment Rate * ROC l Moving terms around, Reinvestment Rate = g EBIT / Return on Capital l For instance, assume that Disney in stable growth will grow 5% and that its return on capital in stable growth will be 16%. The reinvestment rate will then be: Reinvestment Rate for Disney in Stable Growth = 5/16 = 31.25% l In other words,  the net capital expenditures and working capital investment each year during the stable growth period will be 31.25% of after-tax operating income.

25. Copyright ©1998 Ian H. Giddy EquityValuation 2 25 Dividend Discount Model: A Visual Perspective

26. Copyright ©1998 Ian H. Giddy EquityValuation 2 26 The FCFE Model: A Visual Perspective

27. Copyright ©1998 Ian H. Giddy EquityValuation 2 27 DDM and FCFE Values l Most firms can be valued using FCFE and DDM valuation models. Which of the following statements would you most agree with on the relationship between this two values?  The FCFE value will always be higher than the DDM value  The FCFE value will usually be higher than the DDM value  The DDM value will usually be higher than the FCFE value  The DDM value will generally be equal to the FCFE value

28. Copyright ©1998 Ian H. Giddy EquityValuation 2 28 Disney Valuation l Model Used:  Cash Flow: FCFF (since leverage will change over time)  Growth Pattern: 3-stage Model (even though growth in operating income is only 10%, there are substantial barriers to entry)

29. Copyright ©1998 Ian H. Giddy EquityValuation 2 29 Disney: Inputs to Valuation

30. Copyright ©1998 Ian H. Giddy EquityValuation 2 30 Disney: FCFF Estimates

31. Copyright ©1998 Ian H. Giddy EquityValuation 2 31 Disney: Costs of Capital

32. Copyright ©1998 Ian H. Giddy EquityValuation 2 32 Disney: Terminal Value l The terminal value at the end of year 10 is estimated based upon the free cash flows to the firm in year 11 and the cost of capital in year 11. l FCFF 11 = EBIT (1-t) - EBIT (1-t) Reinvestment Rate = $ 13,539 (1.05) (1-.36) - $ 13,539 (1.05) (1-.36) (.3125) = $ 6,255 million l Note that the reinvestment rate is estimated from the cost of capital of 16% and the expected growth rate of 5%. l Cost of Capital in terminal year = 10.19% l Terminal Value = $ 6,255/(.1019 -.05) = $ 120,521 million

33. Copyright ©1998 Ian H. Giddy EquityValuation 2 33 Disney: Present Value

34. Copyright ©1998 Ian H. Giddy EquityValuation 2 34 Present Value Check l The FCFF and costs of capital are provided for all 10 years. Confirm the present value of the FCFF in year 7.

35. Copyright ©1998 Ian H. Giddy EquityValuation 2 35 Disney: Value Per Share Value of the Firm =$ 57,817 million - Value of Debt =$ 11,180 million = Value of Equity =$ 46,637 million / Number of Shares675.13 Value Per Share =$ 69.08

36. Copyright ©1998 Ian H. Giddy EquityValuation 2 36

37. Copyright ©1998 Ian H. Giddy EquityValuation 2 37 www.giddy.org

38. Copyright ©1998 Ian H. Giddy EquityValuation 2 38

39. Copyright ©1998 Ian H. Giddy EquityValuation 2 39 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org